Welcome to this week’s edition of the Carnival of Investing. I’m sticking with my usual method of hosting a carnival — listing a summary of each piece with the author’s reason for submitting the post to the carnival (for those…

I also noticed, on the mutual fund example, you did not reduce the actual investment by the capital gains tax you simply removed it from the rate of return. I would think reducing the gains by the tax would be more accurate. Also, you did not illustrate short term capital gains or AMT.

Finally, you did not illustrate the final capital gains tax when the investor will actually sell the investment at the end of the term. That is an additional 15% or higher depending on tax rates at the time.

Mutual funds are taxed 3 times annual distributions on capital gains, dividends and finally another capital gains tax when you sell it. Versus a 1 time tax on the variable annuity. There was also a study showing that the average investor losses between 2.5 and 5% of their returns due to taxes they must pay on their annual distributions.

Annuities are not perfect, but living benefits and the tax deferral do work for a large portion of Americans. That is my humble opinion of course.

I do agree that annuities provide a good living benefit (a monthly benefit for life). However, I do not see how variable annuities provide a better inflation risk on that monthly benefit just because it is invested in the stock market than one would receive from a fixed annuity with a annual increase (say 3% to 4%) or from a inflation indexed bond fund. From what I see, analysts blame stock market declines on a bump in inflation. So it seems the correlation is reverse (stocks decline when there is unexpected inflation), thus variable annuities do not provide inflation protection, per se.

As for taxes, there are million of ways to do them. I actually thought I was conservative in many situations. Yet, depending on the individual situation, you are right that my example may be different. However, there are a few things to consider if tax deferral is the primary reason to buy a variable annuity:

1) 401(k)s and IRAs provide the best protection at lower fees and most people are not maxing these out which they should before using other tax deferred vehicles like annuities

- Roth IRA is taxed once (at the time that salary is earned and put into Roth IRA)
- Variable annuity is taxed twice - once when salary is earned (like Roth IRA) and twice on the gains in investments (original contribution is not taxed again)

- 401(k) and IRA are taxed once when the distribution is received and with the smaller fees this is (for most) a better option than a variable annuity (unless the fees for variable annuity are so small that it compares to the fees in a 401(k) - which is currently not the case)

2) You are right that my flat tax on the annuity in retirement at 28% would be graduated (10%, 15%, 25%, 28%, 33%, 35%). Yet, if variable annuities are for higher income individuals (who are already maxing out their 401(k)s and IRAs), 28% may be a good estimate because the scenario with and without the annuity would show the difference in income between the two examples is being taxed at the higher graduated rates (25%, 28%, 33%, 35%). In my scenario, the average tax would need to be as low as 20% to get the variable annuity to produce the same return as a mutual fund (or ETF).

3) Yes, there are many examples of how mutual funds and other post-tax investments are taxed. Thus, I usually simplify it to the flat 15% capital gains rate on an annual basis. Again, I do not assume that much short-term gains because if someone is in this for tax deferral (not playing the market for short-term returns) then they would find stocks, ETFs or mutual funds that do not turn over as much producing short-term gains. And, if this is the case, the 15% reduction in returns may be conservative (with the exception of AMT which is different for everyone).

For example, let’s assume a 15 year holding period

Buy and Hold = 1.10^15 - 1 = 317.70 return * (1 - .15 tax rate) = 270% return

My assumption = (10% return * (1 - 15% tax rate)) = 8.5% return
1.085^15 year holding period - 1 = 239% return

Now, no one can have a perfect buy and hold example due to dividends and reallocation that is why I assume it is taxed each year. Yet, I do not assume short-term gains because in holding a mutual fund, ETF or stocks there is always some dividends or re-alignment. I just assume that the re-alignment is minimal (which is probably more true in an ETF that is based on a broad market like S&P 500 or Russell 1000/3000). So again, this should be run by a financial advisor for each person’s individual circumstance.

3) I do not understand your statement that I forgot to tax the mutual fund again at sale. I agree that any gains that were not previously taxed are taxed at that the time of sale. Yet, my assumption was that gains were being taxed along the way, including in the final year when withdrawn. Thus, all gains have already been taxed, so they are not taxed again.

4) With AMT, there are too many examples to go through because some years people may pay the additional AMT tax and other years can have an AMT credit that lowers their normal income tax to reflect that additional taxes that were paid in prior years.

Yet, let’s assume in my example, the 15% capital gains rate is taxed at 26% AMT. Under an annual tax on returns (turning over the mutual fund/ETF or stock), the return does not outperform the annuity

10% return * 26% tax rate = 7.4% return
After 30 years, the return is 1.074 ^ 30 - 1 = 751% return vs. 951% return for variable annuity

Yet, if a buy and hold policy is taken, the return is much better. If you can hold it for 30 years (which is highly unlikely, I agree with),

After 30 years, the return is 1.10 ^ 30 - 1 = 1744% return taxed at 26% AMT rate (or 28% for some) = 1744 * (1 - .28%) = 1255% return vs. 951% return for variable annuity

Now, the return is somewhere between 751% and 1255% depending on how long they can manage to protect the gains from tax. So it may be closer to the 951% return from variable annuity. However this does not consider:

1) That taxed paid for AMT in one year may be credited in later years when tax under AMT calculation is less than the ordinary income tax (thus the 751% low end is increased for lower taxes later on).

2) The fees in my example for the variable annuity was only 0.75% which may be conservative (many annuities charge higher rates when all fees are considered including conservatism in mortality charges)

I hope in this analysis (based on your and my input), people realize that there are many scenarios thus they need to get an independent analysis based on their income, tax structure and investment strategy (not just relying on insurance company scenarios). My goal in the article was to point out two issues:

1) People forget about the extra fee charged to manage the variable annuity in addition to the investment fees (to pay for insurance company profits and commissions) which many (but may not always) wipe out any benefits of tax deferral and that tax deferral can be gotten in other ways such as buy and hold investment policy.

2) They should challenge the assumption that variable annuities are a good protection against inflation when compared to other methods.

Thanks for your comments Scott.

I think VA’s have received bad publicity for years and in many cases, rightly so. The old VA market (80’s and 90’s) was terrible and set up strictly to make the insurance companies money. However, the newer annuity products actually have benefits that are very attractive to most investors. They offer essentially risk-free market investing. Yes, fees are higher but they are going to be for the benefits offered.

Just something to take into consideration.